Biggest 2016 risk may be OIL

The biggest financial risk in 2016 may be OIL.

Financial markets have been going on with the consequences of the energy deflation since mid-2014 and the fallout has been persistent.
More than a trillion dollars of market capitalization has been wiped off oil stocks worldwide.
Almost $2 trillion of debt sold by energy and mining companies since 2010 are facing a wave of credit rating downgrades and defaults are rising.
About 2 trillion euros of European government debt is now yielding less than zero percent after oil-seeded deflation scares forced the inflation-targeting European Central Bank to begin a bond-buying spree earlier this year.
The impact on inflation forecasts of yet another sustained drop in oil prices has been alarming as much for central banks about to tighten, such as the Federal Reserve, as for those still easing, like the ECB.
What’s more, the scale of the hit to commodity exporting nations from Russia to Brazil and South East Asia has stood out. Their currencies have imploded, and 2015 is set to mark the first year of a net private capital outflow from emerging markets since 1988.
Given the scale of the oil price drop, it’s not hard to see why markets have rewritten so many scripts.
Since June 2014, Brent crude has plunged 65 % from $115 per barrel to $40. Much of that implosion happened in the last six months of last year, but any hopes of a rebound this year evaporated amid a toxic mix of a swelling supply glut and steep demand slowdowns in China and emerging economies.
But for all the market risks outlined by banks for the year ahead, ranging from the Middle East conflict and geopolitics, central bank policy ‘mistakes’, market liquidity shocks or even Britain voting to exit the European Union, very few list another halving of oil prices.
And yet, after OPEC meeting broke up in disarray with no agreement on supply cuts or even a reference to production caps, Brent has plumbed new lows below $40 per barrel, while U.S. crude slumped under $37. Even the rolling annual average price, at less than $55, has halved in just 18 months and continues to slide.
Long-term oil price bears Goldman Sachs reckon that any thought of a rebound or even stabilization in 2016 are way off the mark and that US crude could shed almost 50 % from here to $20.
There is a risk that a milder winter, slower EM growth, and the (potential) lifting of international Iranian sanctions will cause inventories to build further. These factors imply that the near-term risks to the forecast remain skewed to the downside. If oil prices breach logistical and storage capacity, they think oil prices could collapse to production costs as low as $20/bbl.
If that proved correct, it would pull out another thread in this year’s already unraveling market and the market stress gets amplified in many different ways, not least in the drain on world markets from lower central bank reserves and petrodollar savings in big energy exporting nations. The rundown of these savings combined with rising Federal Reserve interest rates could well put pressure on long-term interest rates over time.
New investments in global equities, bonds and real estate from oil-fueled sovereign wealth funds are already drying up amid reports of billions of dollars of withdrawals by state institutions from private asset managers.
The foreign assets of the Saudi Arabian Monetary Agency alone are shrinking at an annual rate of more than $120 billion.
“If the global economic expansion continues, as we expect, then rising investment demand will eventually expose the market consequences of ebbing petrodollar saving flows,” says Goldman Sachs.
The combination of lower-for-longer oil and higher real rates could be toxic for corporate credit and emerging markets.
Forecasting a rise in oil and mining sector bond defaults next year and “staggering adverse conditions” for those firms, Moody’s credit rating firm said the only things delaying this in 2015 were temporary cushions in hedging programs, fixed-price contracts and the rundown of existing cash balances.
But that could all change next year if oil prices don’t recover or even continue to fall.
“Diminishing liquidity and restricted access to capital markets are now pushing more firms closer to default,” says Moody’s Managing Director Daniel Gates.
And for those itching to return to battered emerging market equity and debt, the message is clear: “Investors should continue to keep their guard up in 2016,” as Morgan Stanley told the clients.

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